The Bank of Mom and Pop

Person-to-person lending is finally ready to take on banks and credit card companies.

Things were looking so good for Prosper.com five years ago. To most people, the economy appeared to be functional, dot-com nightmare stories had faded from memory, and the time seemed ripe for Web 2.0 to take over the world of personal loans. Prosper and several other "person-to-person lending" sites operated like an eBay for credit: Prospective borrowers put up requests for loans, disclosed their credit rating and the reason they needed the money, and tried to make a case for lenders to take a chance on their dream—at attractive premiums.

Though the idea of perfect strangers trading money seemed surreal, several personal-finance experts said they hoped that companies like Prosper could free borrowers from onerous terms set by credit card companies and, worse, payday loan stores. "Looking at it from 10,000 feet, this is a great idea," Elizabeth Warren, the Harvard Law School professor who is now setting up President Obama's Consumer Financial Protection Bureau, told me when I first wrote about Prosper in 2006. "It could have the wonderful effect of making markets work the way they should, driving down the amounts charged for loans to the true marginal cost."

But that didn't happen. Instead, in 2008, the Securities and Exchange Commission shut Prosper down. Regulators charged that the site was offering investment securities without having formally registered with the SEC. Prosper and its competitors, including Lending Club, were forced to get permission from the government for their operations. Prosper was closed for nine months, and by the time it went back up, the financial crisis had destroyed the public's appetite for financial innovation. Worse, there were signs that Prosper's model was fundamentally flawed. As Ray Fisman wrote in Slate in 2009, lenders on Prosper seemed to be swayed by factors that didn't live up to the claim of democratizing finance—pretty women got cheaper loans than homely ones, and lenders were more likely to lend to white people than black people.

But now things are finally looking prosperous again for peer-to-peer lending sites. Over the past few months, the company has remade its operations in order to reduce lenders' opportunity to unfairly discriminate against certain borrowers. Prosper has also seen the public becoming more interested in lending and borrowing through the site; lending activity is rising, and so far, borrowers are paying back their loans at a rate that keeps lenders coming back. If you put your money in a savings account today you'll get back a pathetic 1 percent in interest. Putting your money in Prosper is far riskier than keeping it in a savings account, but it's also far more lucrative. Over the last two years, the company has delivered an incredible annual return of 10.4 percent to lenders. Its competitor Lending Club has delivered 9.65 percent. "We're starting to build a 'third-way' of banking that looks like a better deal for both sides," Chris Larsen, Prosper's CEO, told me during an interview this week. "We think we can now go straight up against the mainstream banking system."

Peer-to-peer lending rests on the idea that traditional banking is gummed up by unfair bureaucracy. For one thing, advocates of these sites say, credit scores don't accurately reflect a person's ability to pay—people with low credit scores are charged too much for loans even though they may be likely to pay. (This problem has become worse after the financial crisis, when sudden job losses forced even people with high credit scores to default on their loans). There's also a lack of competition. The only companies willing to lend to people with less-than-stellar scores are credit card firms—whose terms are punishingly variable—and payday loan centers, which charge 400 percent or more in interest on an annualized basis.

By putting lenders directly in touch with borrowers—rather than through the banking system—person-to-person lending sites claim that they can cut down on overhead costs, thereby making it cheaper to lend to people with poor credit. They also claim something else: That the peer-to-peer process can evaluate a person's creditworthiness better than a one-size-fits-all credit score, revealing that some people with bad credit deserve access to loans. This seems to be playing out—most of Prosper's and Lending Club's borrowers use lower-rate, fixed-rate loans from the sites to pay off high-rate credit they've accumulated with credit cards.

In Prosper's early days, the company relied on an auction model to determine the credit rate between borrowers and lenders. Borrowers told sad stories of financial woe, explained why they were better credit risks than their scores indicated, and put up honest-looking pictures of themselves. Lenders who were swayed by these pitches chose the rate at which to make loans to these people—the more you liked the borrower, the less you'd charge for the loan. (Lenders diversified their money across many different people; in other words, if you had $1,000 to loan, you'd spread it among 10 or 20 borrowers, so any single default wouldn't wipe you out.)

But Larsen now says that letting lenders determine loan rates didn't work very well. "Credit analysis is a complicated business, and we found that people couldn't accurately determine risk," Larsen says. In addition to the problem of discrimination (giving pretty people cheaper loans), lenders were often swayed by emotional cues into charging too little for risky loans—and when the borrowers defaulted, lenders would blame Prosper for losing their money, and they'd leave the site.

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Last year Prosper removed the lenders' ability to choose how much to charge for loans. Now the site uses its own methods to determine a borrower's credit risk, and then sets a price for loans based on that determination. When you sign up as a borrower, you tell Prosper your financial history, and then it gives you a "Prosper Rating" between AA and HR; this corresponds to an interest rate currently ranging between 5.93 percent and 35.64 percent. Lenders on the site now choose which kinds of borrowers they'd like to invest in, but not how much to charge those borrowers for loans; the riskier the loans you're willing to make, the more you're likely to get back in interest. Prosper has also removed pictures of borrowers from its listings. These two changes have streamlined the way the site operates, and made it much less likely that lenders will lose their money by charging too little for risky loans. (Lending Club, which never used an auction model, operates in a similar way.)

Now that Prosper sets the rates for its loans, it might sound similar to how regular banks operate. But it differs in two important ways. When you deposit your money in a bank, the bank doesn't give you, as a lender, any say in how you want that money invested. You can't tell the bank to give you a higher interest rate because you're willing to stomach the risk of loaning to people with low credit. As a result, banks today refuse to offer unsecured loans to everyone other than folks with the highest credit scores. Larsen says that another way Prosper differs from traditional banking is that it has developed risk models that are much more fine-tuned than credit scores. For instance, Prosper found that people who've already borrowed and paid back one loan from Prosper are much likelier to pay back a second or third loan—and, as a result, they should get cheaper loans.

In fact, the fixed-term loans that borrowers get from Prosper are just the sorts of instruments that many consumer advocates recommend for eliminating credit card debt. Larsen says that the only limit to the site's becoming more useful, now, is a lack of awareness—a lot more people could do well to borrow from the site instead of relying on credit cards, and a lot of lenders could make more money here than they can in a bank.

And Prosper isn't the only tech company looking to improve the opaque, closed-off world of finance. It's part of a range of new ventures—including Mint, Square, Kickstarter, and others—that seek to bring a startup ethos to the business of keeping, lending, and borrowing money. There's now even a twice-a-year conference, called Finovate, devoted to these businesses; at the conference, a parade of startups line up to show off their plans to revolutionize finance, and many of them find instant investor backing for their ideas. It might not quite be the dream of a truly democratic determination of risk and credit, but it's one of the brightest hopes in a credit market still shell-shocked from the recession.

Farhad Manjoo is a technology columnist for the New York Times and the author of True Enough.

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